Readers, we ask for your help in this post to solve a complex matter: how do you define liquidity for repo-style transactions under Basel III? If you are able to comment below, please do. If your company prohibits public comments, please feel free to respond to us directly at email@example.com.
There is little doubt that Basel III will impact the repo business model, but some confusion has developed as to what Basel rules mean by “liquidity” and “repo-style transactions.” The Basel Committee, the Bank for International Settlements, the Financial Stability Board and most everyone else has a lot to say about repo these days, but Basel rules have made a loose definition of what liquidity for repo-style transactions actually means.
In fact, repo got a pass in the revision of Paragraph 179 in Basel II, which generally places the liquidation period for repo and repo-style transactions to five business days (vs. ten days for derivatives). That’s fine and clear, but when an argument needs to be made about the “liquidity” of repo, Basel III does not provide any direction that we can find.
The Liquidity Coverage Ratio (LCR) rules as regards repo are better understood: they are intended to modulate the cliff risk that seems to permeate the repo business. Finadium has delved into this issue on a couple of occasions including in our October 2011 report, “Capital Charges for Margin, Securities Lending and Repo.” As we noted then, “for repo traders, it will be important to understand if a bond is included in [High Quality Liquid Assets] and in which bucket. The more paper that is in the HQLA pool, the numerator of the LCR calculation, the better.”
While LCR rules differentiate between collateral types and have the general impact of discouraging less credit worthy collateral, we see no requirement to constrain the actual types of collateral used in repo transactions. It seems to us that as long as the funding is structured to mitigate the funding shock risk (aka, keeping the LCR in check), then it’s ok. Under Basel III securities financing transactions and repos are also allowed to be netted, a la Basel II.
Hence, our argument is that repo transactions can continue to include any sorts of collateral that a bank is willing to take: there are no prohibitions under Basel III that require NOT taking specific collateral types. We think that the broader collar is the LCR; too much low quality assets and the LCR will not pass muster. However, we understand that not everyone feels this way, and some think that the only acceptance repo collateral types are those that fall into Level 1 and Level 2 assets. These buckets are the right way to define the LCR (as of today – watch this space) but we don’t think that they are the right qualifiers for getting to what repo types are acceptable. We think that if a bank were feeling nervous, looking at what CCPs accept might be a better proxy.
Readers, what do you think? Does your organization have a working definition of liquidity in the repo market under Basel III? We will publish a synopsis of the responses we receive.
Links to two helpful (or not) publications from the BIS are here and here.